You are the CFO of a manufacturing company in the United States. Your company expects to receive a payment of 10 million Euro from a European customer in six months. The current exchange rate between US dollar and Euro is 1.05 USD/EUR. You are afraid that Euro may depreciate against the US dollar in the next six months. You have the following financial derivatives contract to choose to hedge the foreign exchange risk.

Contract 1: A 6-month forward contract of 10 million Euro currency with a forward exchange rate of 1.06 USD/EUR.

Contract 2: A European call option on 10 million Euro currency with a strike price of 1.06 USD/EUR. The option contract expires in six months from now. The option contract premium is $0.02 per Euro.

Contract 3: A European put option on 10 million Euro currency with a strike price of 1.06 USD/EUR. The option contract expires in six months from now. The option contract premium is $0.01 per Euro.

(1)Explain how you would use the forward contract to hedge the Euro exchange rate risk. Can you also use call or put option to hedge the Euro exchange rate risk? Specify your trading strategies (i.e. buying or selling the forward contract; buying or selling the call or put option).

(2)Assume you hedged the Euro position using either the forward contract or the option contact. Suppose the exchange rate between Euro and US dollar turns out to be 1.10USD/EUR at the end of the six months. Calculate and compare how much U.S. dollar your company will receive by selling the 10 million in six months based on the forward contract or the option contract. Also calculate and compare the gains or losses on the forward contract and the option contract.

(3)What if the exchange rate between Euro and US dollar turns out to be 1.00 USD/EUR at the end of the six months? Calculate and compare how much U.S. dollar your company will receive by selling the 10 million based on the forward contract and the option contract. Also calculate and compare the gains or losses on the two contracts.

(4) Draw the payoff diagram for the forward contract and the option contract.